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Its all becoming clear

"In 2008, only a fifth of US-issued interest rate swaps were cleared. By the end of 2013 more than half were being cleared"

Clearing houses are becoming a key risk management tool for trading firms. And their role is set to expand significantly over the coming years, as Luke Jeffs explains.

The collapse of Lehman Brothers prompted a global reassessment of financial markets. Derivatives came under particular scrutiny and in 2009, G20 leaders pledged to initiate change

Since then, US regulators and their European peers have been working on plans to force the most popularly traded OTC derivatives, interest rate swaps, to pass through clearing houses.

US regulators took the lead on implementation. In September 2013, the Commodity Futures Trading Commission (CFTC) completed a phased roll-out of swap clearing for banks, hedge funds and other financial institutions. And just one month later, the Commission forced hedge funds that trade the US markets from outside that jurisdiction (typically the Cayman Islands) to start clearing also.

For its part, the European Commission plans to introduce swap clearing in late 2014 or early 2015, through its European Market Infrastructure Regulation (EMIR) reforms.

Historically investors such as asset managers, hedge funds and insurers traded swaps bilaterally with investment banks and specialist brokers, meaning they were exposed to the risk that their counterparty might go bust and default on any outstanding trades.

But the demise of Lehman Brothers in 2008 and futures broker, MF Global in 2011 brought these dangers to the fore and convinced regulators that more traded markets need to use clearing houses to manage their risks.Clearing houses demand deposits from trading firms, which are held to ensure that no firm is left out of pocket by the collapse of another firm with which it has traded.

Firms that clear their trades are effectively replacing their exposure to their trading counterparty with exposure to the clearing house, also known as a central counterparty (CCP).

Thanks to regulatory change in Europe and the US, all trading firms, including fund managers, hedge funds and insurers, will now be responsible for clearing their own trades.

Global policymakers are also seeking to make central clearing via a CCP more attractive to trading firms through other initiatives such as Basle III, the regulatory standard on bank capital adequacy, which makes cleared trades cheaper to process than those that are not cleared.

First steps

Client clearing, as it is known, has actually been available since 2009 when LCH.Clearnet, now part of London Stock Exchange, became the first CCP to allow asset managers, hedge funds and smaller banks to clear their swap trades directly with the central counterparty itself.

And client clearing has been growing steadily since then, as trading houses have started using the service both to tackle the risk of a counterparty default and to prepare for forthcoming regulation.

The introduction of US rules mandating clearing for new swaps(already issued swaps are exempt) was the biggest boost for client clearing however.

“LCH.Clearnet saw client clearing activity consistently intensify in the run-up to each of the CFTC’s various clearing deadlines in 2013,” says Daniel Maguire, head of Swapclear US, the North American arm of LCH.Clearnet's global clearing service for interest rate swaps.

In 2008, only a fifth of US-issued interest rate swaps were cleared. By the end of 2013 more than half were being cleared, equating to $180 trillion of a $330 trillion market. The CFTC expects this level to hit two thirds in 2014 and rise still further after that.

“The regulation in the US applies to newly issued swaps but we are seeing clients clearing their existing contracts also. Central clearing is obviously here to stay and clients do not want to maintain two operational processes for one set of products,” says Maguire.

European policymakers are still working on their EMIR clearing rules and the use of client clearing for swaps is still voluntary but there are already early adopters, specifically larger hedge funds, asset managers and regional banks, looking to implement and test their new clearing processes ahead of the regulatory deadline.

“In Europe, most clients are not yet clearing because there is no mandate to do so but once the European implementation dates are known I expect there will be a very different picture, with clients looking to get ahead of the game through the end of 2014 and into 2015,” says Gavin Dixon, global co-head of fixed income clearing at BNP Paribas.

Preparing for change

Client clearing is no small undertaking, however. Asset managers, hedge funds, regional banks and insurers looking to start clearing for the first time are faced with a range of legal, technical and commercial challenges.

Firms are required to redraft legal agreements with trading counterparties, implement computer systems to support the process and select a clearing broker to facilitate clearing on their behalf. Under the new rules, clients will also have to give up a significant amount of control to their clearing brokers, which can represent a psychological challenge.

“Currently firms are selecting and on-boarding their first clearing brokers but they are not yet clearing all of their business because it is more expensive to do so. This is going to change though as regulation impacts non-cleared trades also,” says Dixon.

The world’s top clearing houses have been developing new solutions to appeal directly to this new user community, improving their liquidity and collateral management services to support increased clearing. In late 2013, for example, LCH.Clearnet agreed to work with global message network Swift to streamline the passage of collateral messages between the clearing house and its clients.

The reforms to mandate client clearing of swaps may have taken time to become law, but US investors are now working through its implications while European clients are starting to come to terms with the implications of this new regime.

“Given that global dealers and the US market are now mandated to clear swaps, the part of the market that is not clearing has shrunk further and this is only going to continue. The market is nearing a tipping point on clearing,” says Maguire.